Thursday, May 24, 2012

When analyzing incoming economic data, it is important to view it from the perspective of the market's expectations. In my view, the extremely low level of Treasury yields (and the same goes for sovereign yields in most developed countries) is a strong sign that the market's growth expectations are dismal at best, and downright dreadful at worst. Similarly, price/earnings multiples on the S&P 500 of 13.4 and forward multiples of 12.2, at a time when corporate profits are at all-time highs, both in nominal terms and relative to GDP, can only mean that the market is expecting a significant decline in future earnings, which in turn is likely only if the economy is on the verge of another recession. Moreover, when there are $6.3 trillion of retail savings deposits earning almost zero at a time when earnings yields on equities are 7.5%, one is forced to conclude that a significant portion of the population is still in the grips of fear. In short, both the bond and stock markets are priced to the expectation of an imminent recession that could prove substantial.

With that said, today's economic releases reflect an economy that is improving, but only slowly. Is that something to worry about? No, because even a slow-growing economy is much better than what the market is expecting. In that light, today's news is a reason to be bullish.

The level of weekly unemployment claims has been choppy of late, but shows no sign of any deterioration in the economy. As the above chart suggests, the recent correction in equity prices is just that, a correction; the market was worried that the rise in claims in early April was a harbinger of another recession, but as it turns out it was most likely just an artifact of seasonal adjustment problems. Non-adjusted claims have been low and flat for the past several months, and last week's number was down 13% from a year ago, so on balance claims are still pointing to a slowly improving labor market. In the absence of any actual deterioration, stocks are likely to turn back up.

The number of people receiving unemployment insurance continues to decline, and is down 17% from a year ago. This is a positive indicator, since it means that those who are still looking for jobs have a greater incentive to find and accept job offers. And of course, it also reflects the fact that the ranks of the employed continue to expand, albeit relatively slowly.

New orders for capital goods, a proxy for business investment, have shown almost no growth since last summer. This is disappointing, since it would be much better to see continued increases. But it is not a sign of recession, and at worst it simply reflects what might be termed a economic "soft patch."

Swap spreads are good indicators of systemic risk, and they can also be good leading indicators of overall economic conditions. In the chart above we see that spreads in the Eurozone are quite elevated, and that makes sense given the ongoing difficulties with sovereign default risk. U.S. spreads have inched higher, but are still well within the range of "normal." Europe is having problems, but the U.S. has so far been unaffected, even though the market continues to worry about contagion risk.

As this chart of credit default swap spreads shows, the market is still quite worried about the risk of corporate default risk. Spreads today are at levels that we saw at the beginning of the last recession, and this is a clear sign that the market is priced to a recession, even though we have yet to see any signs of a downturn.

As a reminder, the chart above shows the trailing PE ratio of the S&P 500. At 13.4 today, it is approximately equal to what it was at the end of 2008, when the market fully expected a multi-year global recession/depression and years of deflation.

And as another reminder, this chart shows after-tax corporate profits as a % of GDP. We've never seen anything close to this good. The market's current PE ratio can only imply the expectation that profits are going to collapse, and that would only occur if the economy lurches into another recession.

Skeptics will be quick to point out that corporate profits are likely to exhibit mean-reverting behavior relative to GDP, and so today's very high level almost guarantees that profits are going to significantly underperform in the years to come—and thus the market is correct in assigning a very low multiple to current earnings. My rebuttal comes in the chart above, which shows that as a % of world GDP, corporate profits today are not unusually high at all. The globalization of most large corporations has brought significant advantages to U.S. business. Firms that can address a significantly larger global market can expect to earn profits that far exceed what was possible when U.S. firms were limited to just the U.S. market. Think Apple, which appears to have doubled its share of the booming Chinese smartphone market in just the past quarter.

The U.S. news may not be very exciting these days, but it is far better than the market's expectations. Thus I think it pays to remain bullish, even in the face of the "fiscal cliff" that is approaching at year end. The world is rapidly learning that lots of government spending does little or nothing to boost an economy, and that less government intrusion in the economy is much better for growth than boosting taxes. (See my previous post for more on this.) I think it will be very difficult for anyone in Congress to argue convincingly for allowing a big increase in tax burdens to occur starting January 1st. And I don't see a constituency in favor of ramping up government spending either. I note that Congressional gridlock has already resulted in a significant decline in the federal budget deficit as a % of GDP in recent years (from 10.4% to 7.4%), and a welcome decline in federal spending as a % of GDP (from 25.3% to 22.7%).

Everything is bullish! Even the possibility Scott is a "virtual", Fed-paid blogging personality, one who manages to write 6 posts with immaculately formatted charts while pretending to ski at the same time. Even removing THIS post is bullish!

Wall Street Journal:"The Kansas City Fed’s manufacturing composite index–an average of the indexes covering production, new orders, employment, delivery times and raw-materials inventories–rebounded to 9 in May after falling to 3 in April from 9 in March. Readings above zero denote expansion.

On a year-over-year comparison, the composite index increased to 27 from 24."

Assuming Scott is correct, a Greek meltdown has already been priced into the markets -- I tend to believe that a Greek meltdown will create a stock market correction, which means more buying opportunities for bargain price equities -- long-term equity investors are in an historic buy window of opportunity -- "...the future looks bright, gotta wear shades..."

PEs go up when investors expect rapid growth or are looking farther into the future for their return. A slow growth economy depresses PEs. Not many investors can look into the future with enthusiasm. Maybe stocks are priced “fairly”.

Markets are 'in between'. In between the start of the recovery that coincided with the low point for the last recession and the point in time when growth has expanded far enough and long enough to create sufficient cyclical traction to start a rising trend for the laggard sectors. The problem is that at present we have no way of knowing how long it will be until traction shows up. So... we have to keep busy focusing on a variety of other perspectives to help pass the time. The years leading up to 2008 the calendar was essentially split into two six-month time frames with a 'strong energy and base metals' trend dominating the markets from January through June and 'something else' kicking into gear from July through December.The term 'something else' is obviously quite vague but that is actually the best way to describe it. In 2007 the first half of the year featured a very strong price trend for gasoline futures along with a bullish response from oil refiner Valero. By the start of the third quarter in July the trend simply... reversed.The first six months of 2008 included not only a powerful rising trend for crude oil prices but also sympathetic strength for almost everything related to energy including nuclear, gas, oil, and even coal. The share price of Arch Coal doubled through the first half of 2008. When the energy trend finally turned negative in July virtually everything related to growth and risk collapsed.Equity/Bond MarketsThe argument is that prior to 2008 the markets were pushing energy and base metals prices higher over the first half of the year and then rotating over to 'other sectors' for the final six months. 'Other sectors' included everything from the consumer stocks to the airlines and even bonds and gold. The next point is that the broad stock market reacted to the mid-year trend change in a variety of ways.In general the equity markets have trended with cyclical growth. In general the equity markets have trended with energy and base metals prices. In specific, however, this has not always been the case and this is the detail that makes our work quite challenging. Two points. First, yields tend to trend with cyclical growth. This explains why 10-year yields moved higher over the first half of 2006 and then lower over the balance of the year. Second, the way the S&P 500 Index reacts to changes in interest rates varies. We cannot write that the SPX will decline if yields decline- although that is often the case- because we can show an example like 2006 when the SPX drove to the upside as yields moved lower. In recent years the cyclical trend between Treasury yields and crude oil was positive from January through June and then negative from July through December. The trend for the broad large cap stock market will vary from year to year. In 2008 the stock market collapsed on oil price weakness while in 2006 the trend was relentlessly higher. The next argument is that we are still seeing six month bouts of cyclical strength and weakness but... the time frames have shifted. Instead of January through June we appear to be working off of an October through March cycle.Oil prices were stronger from October to March in both 2010- 11 and 2011- 12. As crude oil prices rose the trend for bond prices was lower. The argument is that if nothing in particular changes... we could see downward pressure on energy prices into the autumn along with upward pressure on bond prices.